If you have ever read Thinking, Fast and Slow by Daniel Kahneman (who, along with Amos Tversky, has been credited with being the father of modern behavioral economics), then you know how easily we can be fooled by our assumptions, fears and false intuitions.
This is why it’s useful to remember some key principles when we make decisions about money (in addition to, of course, the regular practices of following a budget, saving, investing and avoiding most kinds of debt).
Whether you’re creating a budget or making investment and savings decisions, here are four things that you should keep in mind:
1) Opportunity costs
What do you need to give up in order to get something you want? It’s almost always a question of money, but also one that involves time and value.
Pursuing an advanced degree may take years—are you willing to put in that amount of time? Will a sports car give you enough enjoyment to offset going into debt for it?
Whenever you make a decision about how to invest your money, you should always remember to think about how it affects your time. Sometimes it really does pay to invest in a lawn care service so that you can free yourself up to do more “valuable” work.
2) Sunk costs
This is money you can’t get back—a non-refundable airline ticket, for example. The idea here is that you need to keep sunk costs in the proper perspective. It’s easy to start thinking, “Well, I’ve already spent $100, so what’s another $25?” But sometimes, you’ve got to be willing to walk away.
Once something is paid for, and cannot be refunded, it shouldn’t impact your future financial decisions. It is a “sunk” cost, i.e., water under the bridge, and whatever you do in the future won’t ever get it back.
3) The Rule of 72
Want to double your holdings? The Rule of 72 can tell you how long it will take, based on the specific interest rate. Just divide 72 by the interest rate.
For example, if you’re looking at an investment with an interest rate of 6 percent, then 72 divided by 6 gets you an answer of 12 years.
This is a rough estimate, of course, but it’s pretty effective.
In fact, you can also turn the equation around to determine the interest rate you’re looking for if someone promises to double your returns in a set amount of time. Twice as much money in 12 years? Divide 72 by 12 and you get an interest rate of 6 percent. This rule lets you evaluate investment opportunities quickly and decide where to put your money.
4) Now > Later
According to this principle, a dollar you receive today is worth more than a dollar you’ll get tomorrow. You’ll have opportunity to invest that dollar immediately and begin earning more revenue from it (and avoid losing value because of inflation).
Again, this helps you make certain calls about your purchases—and your income. It’s the old “a bird in the hand” theory in action.
Thinking about money in terms of these four principles has served me well over the years, and I think they’ll help you (and your wallet) as well.